The inflation outlook has deteriorated since the last MPC meeting, at least in the near term, and real Central Bank rates have fallen. Recent data do not materially change the overall outlook for growth and employment. However, given recent announcements, the outlook is for a more expansionary fiscal stance than previously forecast.

Headline inflation has increased for four consecutive months, reaching 3.4% in May, and will likely remain elevated through next year. However, core inflation still remains close to target. The increase in inflation reflects a weak króna and the recent rise in commodity and oil prices. To the extent that the króna is broadly stable and these price increases are temporary, they are unlikely to have a lasting effect on inflation over the medium term.

Given the current exchange rate, however, pay increases implied in recent wage agreements are not consistent with the inflation target over the medium term. As the recovery progresses, wage pressures stemming from the traded goods sector may therefore cause longer-term inflation expectations to drift upwards. To reduce the risk of such an outcome, tighter monetary policy may become warranted in the near term, with actual policy moves depending, as always, on developments and prospects.

The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

“Iceland is obliged to ensure payment of the minimum compensation to Icesave depositors in the United Kingdom and the Netherlands, according to the Deposit Guarantee Directive.” This is the conclusion in a reasoned opinion on 24 pages the EFTA Surveillance Authority, sent to Iceland Friday June 10. Further, ESA concludes:

In its emergency response to the banking crisis in October 2008, the Icelandic Government made a distinction between domestic depositors and depositors in foreign branches. Domestic deposits continued to be available after they were taken over by New Landsbanki, whereas the foreign depositors lost access to their deposits and did not enjoy the minimum guarantee. It is not possible to differentiate between depositors to the extent they are protected under the Directive. By acting as it did Iceland failed to ensure that the depositors received the compensation to which they are entitled under the Directive.

The Icelandic Government is now requested to take the measures necessary to comply with this reasoned opinion within three months. Should Iceland not comply, the Authority will need to consider taking the case to the EFTA Court.

An overview of the opinion is found in the ESA press release that also has links to earlier documents regarding Icesave.

As stated above, Iceland now has three months to fulfil the Directive. All this had been negotiated and settled in the Icesave III agreement. Now there is the order to pay, in addition to the interests on the loans to the UK and the Netherlands as they paid out their Icesave depositors.

The saving society Byr wasn’t among the heavy-weights in the Icelandic financial world. These days, two previous Byr managers and the CEO of MP Bank are on trial in Reykjavik following an investigation by the Office of the Special Prosecutor. Today, prosecutor Bjorn Thorvaldsson demanded a jail sentence of five years for Jon Thorsteinn Jonsson chairman of the board of Byr, its CEO Ragnar Z Gudjonsson and MP Bank’s CEO Styrmir Thor Bragason for breach of fiduciary duty. In addition, Bragason is charged with money laundering.

The investigation centres on two overdraft loans, in total ISK1bn (now €6m), from Byr, in October and December 2008 to a holding company, Exeter Holding. In October, as the banks were collapsing and Byr hardly lending anything at all, Byr lent ISK800m to Exeter, which proceeded to buy Byr investment from Jonsson and others related to Byr at a rate not seen elsewhere on the market. It so happened that these Byr people were being pursued by MP Bank with margin calls since MP Bank had earlier lent a group of Byr employees to buy into Byr.

It wasn’t until late December 2008 that the board of Byr was told of the ISK800m loan. At the same meeting, the loan was increased by ISK200m. The board of Byr was told that the additional loan was to serve interests and cost of the previous loan. In fact, the ISK200m was used to buy Byr investment from a certain Birgir Omar Haraldsson who at the time was an alternate on the board.

The money paid into Exeter flowed into MP Bank, at a time when liquidity was scarce. The Exeter deal solved personal problems for many key employees at Byr and for MP Bank.

But who was the owner of Exeter, the company chosen to do the deals? The owner was an investor, Agust Sindri Karlsson, who in 1989 was one of the founders of MP Bank and sat on the board of MP and other related companies until summer of 2008 when he left all these boards, upset that the bank was making what he felt were unjustified margin calls on him. Intriguingly, at the same time that Karlsson was being chased by MP to pay his debt with the bank the CEO of MP found Exeter, as a party in the Byr deal, adding ISK1bn to the Karlsson company sphere that was already over-indebted.

The Byr managers are charged with breach of fiduciary duty, sacrificing the interests of Byr for themselves and a few Byr-related parties. Bragason is charged for participating in their illegal activity, as well as money laundering when he received money procured by criminal action. The three deny all wrongdoing.

Byr has been in the news since 2009 when a couple, Sveinn Margeirsson and Rakel Gylfadottir, who had invested in Byr, became suspicious of the Byr management. They set up a website, Margeirsson was elected on the board of Byr and from within he was able to track relevant document and the course of action that laid bare serious breach in lending to related parties. The couple handed their documents to the OSP that pursued the investigation. If there had been more people like the inquisitive couple, the situation in Iceland would have been different.

The Byr loans don’t amount to much, compared to the lending of the three big banks to favoured clients. But Byr shows all the trends of the big banks in a nutshell.

Byr broke its own rules on collaterals, loan ratio and loans to related parties. It lent to a company, Exeter, with a negative equity, owned by a heavily indebted individual. All of this characterised loans to the favoured clients of the Icelandic banks: loans that were only for the well connected few.

It’s also clear from the Exeter loans that the Byr managers, who originally got the loans from MP Bank to buy into Byr, believed at the time they were making a ‘risk-free’ investment. They didn’t expect margin calls and such nuisance. The loans were supposed to be ‘risk-free’ for the investors whereas all the risk was shouldered by the lender who didn’t take the necessary precaution in securing collaterals and guarantees.

It’s also symptomatic for the two Exeter loans that they were tunnelled via a SPV owned by a man who was already heavily indebted to MP Bank. In return, MP Bank seems to have stopped making margin calls on him. As seen elsewhere, there seems to be a certain quid pro quo, built into the transaction.

Compared to cases where the OSP might later bring charges the Exeter case is a simple one. A clear case of crude breaches. The three charged were unknown outside the Icelandic banking world. If the managers and the big owners of the three big banks in Iceland will ever be charged it’s clear that they will buy the service of the best lawyers in Iceland and no doubt seek foreign advisers. That will be a real test for the Special prosecutor and his team. The Exeter case was a dress rehearsal for the great legal spectacles to come.